Focus on the Fallen Angels

For the year ahead, investors and traders alike need to learn to think differently from everyone else in the markets. In 2012, we found plentiful evidence that the biggest losers in the S&P 500 offer significant trading opportunities and that they frequently stage sharp fast rallies. Trading the falling knives instead of the glamorous darlings may give investors and edge as they put their tools to work in a less crowded playing field.

This thought is consistent with some of the research done by the Brandes Institute and others. I have a still-to-be-tested theory that bottom fishing is even more productive today as a result of ETF and index trading. These tend to have a bullish bias in my experience and provide a source of buying pressure for broken stocks. Once the fundamental selling is over, the blind buyers in the ETF marketplace reassert themselves and the stocks quickly correct. Even if my theory turns out not to hold water, the worst performing stocks are more likely to meet my fundamental criteria than the leaders, so it can still be a fertile shopping ground for stock ideas.

The worst performing stock in the index is Apollo Group (APOL). Even though the shares are down 60% over the past year, I still cannot bring myself to buy the stock or cover my short. The business model for the education industry is broken and I do not see a quick fix in the works anytime soon. I believe student signups and total enrollments will continue to decline next year and the stock will continue to go lower.

Best Buy (BBY) makes the fallen list with a decline of almost 47% in the past year. I am hearing chatter about a takeover by the CEO or even a private equity buyout. However, the company trades for more than 2x tangible book value and I will pass on any retailer at that level. Margins and earnings will be weak again next year and I see no reason to buy the stock. The same applies to J.C. Penney (JCP). In spite of Pershing Square Capital Management's Bill Ackman's constant and convincing presentations, the business is not good enough and the stock is not cheap enough for me to have any interest at this level.

I have been long and wrong in Cliffs Natural Resources (CLF) for a good part of the second half of 2012.The largest supplier of iron ore to the North American teel business is likely to see weakness for at least the first half of 2013 because the steel markets remain very weak. The company has idled some domestic plants and taken other cost control measures. Eventually, the economy will recover and this stock will become a growth name once again. For now, the shares pay a comfortable yield of 6.4% and I am willing to ride out the bumps with my usual "stay small and move slowly" position. If the stock were to trade below tangible book value of $35, I would be willing to add a little more, scaling into additional shares.

Hewlett-Packard (HPQ) is on the list as well after declining 40% in 2012. I have been tempted several times -- especially when some noted investors purchased substantial stakes in the company. However, I have gotten better at sticking to my discipline over the years and refuse to buy the stock until it trades at a substantial discount to my current estimate of liquidation value of $10. Around $8, I might be a buyer. Until then, I shall resist all temptation to buy a badly broken company that is struggling to execute a turnaround.

On a tangible book value basis, the cheapest stock on the losers' list is Chesapeake Energy (CHK). After its CEO was found to have engaged in some improper transactions with corporate lenders last year, this controversial company has attracted all the wrong kind of attention. The company also felt the same pressure as everyone else in the business from low natural gas prices. Chesapeake has announced a plan to grow production by 25% and cut debt by 25% over the next two years. If the company is successful, the stock could return to its past levels. After falling more than 25% in the past year, the shares now trade at just 70% of tangible book value. Carl Icahn and Mason Hawkins of Southeastern Asset management have both taken activist stakes in the company and are committed to pushing through asset sales and leading a turnaround. I think you can put in your sights on this stock as a buy for 2013.

Shopping among the biggest losers can be a fertile source of new ideas. Not all of the companies will be a screaming buy, but it is a useful activity to add to your research process. Traders and investors alike should be focusing on the unloved fallen angels to gain an edge on the market that can help keep the bottom line in the black.